Word of The Day – Risk Parity Funds

Risk parity funds

The idea of risk-parity is based on an ages-old distinction between stocks and bonds.

Bonds are said to safer because when a company goes bankrupt, stock holders get zapped first. Bondholders get zapped second. Stocks are said to be riskier than bonds; therefore they should pay higher returns than bonds.

Why are risk parity funds a bad idea? In 2007 quants, finance whizzes who use computers to tell them what to buy and sell, invented Residential Mortgage Backed Securities (RMBS) that made the very same promise. And we all remember what happened in 2007!

The mortgage market meltdown was just the first indication of troubles on Wall Street in 2007.

Today the prices of mortgage derivatives similar to RMBSs are now the determinants of housing prices. The price of a house isn’t set by supply and demand anymore. It is set by the expected amount of capital gains over the lifetime of the buyer’s mortgage. The amounts of those expectations are set by the creators of mortgage derivatives.

In other words, speculators in housing markets are still free to create bubbles that burst.

What are risk parity funds?

Risk parity (RP) funds are combinations of stocks, bonds and commodities all balanced out by computer algorithms to provide a stable “bond-like” total risk to fund manager’s portfolios while paying high interest rates similar to those of stocks. Risk parity funds are sold by wealth fund managers to “sophisticated” investors.

As of now they’re still a small part of the market, measured in mere billions, not trillions of dollars like other money market investments. But RP funds could become a big problem in the event of another financial crisis.

This summer the markets have been spooked by the Eurozone crisis (i.e. Greece); the Fed’s ever-changing pronouncements about raising the overnight interest rate that banks pay, and most recently China’s stock market meltdown and the ensuing crash of emerging market (EM) stocks around the world.

Risk parity is supposed to balance on the risks on stocks, bonds, and commodities, but the above-named crises just this summer have affected all three of these markets: sovereign government bonds, stocks, and most recently the commodities market—and even global real estate.

Strategists from JP Morgan are forecasting that in the futures market (used largely by big banks to hedge risk), or with risk parity funds, and/or with commodity-trading strategies based on risk assessment, there could be a “negative feedback loop” or in plain English, a downwards spiral of selling that begets even more selling.

Other investing commentators agree that risk-parity funds have been a drag on the market and may continue to be so for the next few months.

A report by AllianceBernstein found that RP funds include “juiced up” derivatives or debt in order to spice up the bond-returns part of the funds to match the returns of stocks in these funds. However, losses from bonds can force widespread sell offs of stocks in order pay for bond losses.

While derivatives are useful in stable markets for hedging bets, no one has yet figured out what their effect is during market panics. In stable times, derivatives may appear to be as safe as US government treasury bonds, but during market downturns it’s a very different story.

In the event of a liquidity freeze (i.e., the withdrawal of money from the market by wealthy speculators who make “naked” (risky) bets to close up the end of a chain of derivative-hedging deals among more conservative banks and investors, all kinds of derivatives, even quality derivatives could become un-sellable.

This year JP Morgan’s index of 17 risk parity funds showed that these funds dropped 8.2% in value since May. As this market becomes more popular, risk parity may become more problematic for all types of investors.

JP Morgan’s risk parity report alleges that volatility-risk computer strategies caused the mini-flash-crash of August 24. on this summer. The recent 3% drop on the S&P 500 this month is seen by some as caused by RP selling.

What can you, as a small “retail” investor or retirement fund owner do to protect yourself against moves by large traders?

First, keep an eye on the VIX index of volatility. The VIX went from a long-term average of 22 up to 56 when the China crisis hit. Large investors who use risk rates to calculate when to get in and out of the market frequently panic and put their money into cash during periods of uncertainty